The Wall Street Journal | Easing the Sting of Falling Stock Prices

In this year’s tumultuous stock market, mutual funds that follow alternative investing strategies have given investors some respite.

During the July-August stock slide, alternative-investing categories such as currency funds, market-neutral funds and managed-futures portfolios eked out very small losses compared with the overall decline in the Standard & Poor’s 500-stock index, according to data from fund research company Morningstar Inc. Other alternative categories, such as long/short stock funds and funds that combine multiple alternative strategies, suffered declines, but their average returns still outperformed those of benchmark indexes as well.

While alternative mutual funds performed relatively well during the recent market crash, some have pointed to a disappointing long-term performance.

Still, Mallory Horejs, alternative-investments analyst at Morningstar in Chicago, says there are a couple of reasons why having exposure to alternatives can limit losses when the stock market is tumbling. Some funds sell stocks short (in a bet prices will fall), some invest in nontraditional asset classes like foreign currencies, and some do both. The varied strategies they pursue can make alternative funds less volatile than traditional stock funds.

Investors need to have realistic expectations. Alternative funds “are designed to take risk, and thus they too will have periods of positive and negative returns,” says Ronen Israel of fund manager AQR Capital Management. And while their performance isn’t closely correlated to that of stocks, alternatives “are also not guaranteed to go up when equities go down,” he says.

Over the past several years, in fact, as alternative funds have proliferated, numerous poor performers have been liquidated or merged out of existence.

Smaller Drops

For a broad gauge of the performance of various alternative funds in a downturn, consider the period of July 22 to Aug. 8, when the S&P 500-stock index fell 16.6%. Currency funds, by contrast, which generally hold non-U.S. currencies and benefit when the dollar weakens, were down just 1.6% on average, according to Morningstar. Managed-futures funds—which use futures to invest in trends in the stock, bond, currency and commodities markets—fell 1.5%.

Among market-neutral funds, which buy some stocks and sell others short, the average loss was 2.2%. Market-neutral funds aim to balance their long and short exposures so that results are driven by the relative performance of the stocks and not by the market’s overall direction.

Long/short equity and multi-alternative funds fell more during the decline because, among alternative funds, they have the highest exposure to the stock market. In long/short funds, where the long exposure is typically greater, the average return was minus 7.4%. Multi-alternative funds fell 4.6% on average. These funds allocate to several strategies, providing a one-stop choice for alternatives investors, but long/short funds usually form the core of the portfolio.

To be sure, holding up better than a benchmark in a brief market tumble doesn’t necessarily translate into strong returns over longer periods. Still, several types of nontraditional funds are looking good over the first nine months of this year, which has otherwise been a generally dismal period for investing, featuring a negative 8.7% return for the S&P 500. The average returns for the following alternative categories during this period are all negative, but they are down less than the benchmark: market-neutral funds, down 0.3%; currency, down 3.2%; multi-alternative, down 3.9%; managed futures, down 4.7%; and long/short, down 6.9%.

Investors should be aware of the different ways that alternatives tend to react during a big upward move for stocks. While long/short and multi-alternative funds are more vulnerable to stock-market downturns than, say, market-neutral funds, they also have more upside potential when stocks trend higher. Market-neutral funds, which hedge out most equity-market risk, aim to provide small but steady returns in all conditions, says Morningstar’s Ms. Horejs. They will rarely provide blockbuster returns…